Resilience Amid Competing Narratives

The US economy has remained resilient despite growing headwinds, including higher energy prices, elevated interest rates, persistent inflation, geopolitical tensions and rising concerns about the pace and safety of artificial intelligence development. Second-quarter real GDP grew at an annualized rate of 2.2%, following 2.5% growth in the first quarter. Consumer spending remains the primary driver of US economic growth, rising 2.5% over last year and up sharply from the first quarter. However, massive investment in AI infrastructure and related capital expenditures also contributed meaningfully to growth, adding approximately 1.3 percentage points.

Third-quarter real GDP growth is expected to approach 3.5%, again supported by consumer spending and the AI buildout. Together, these forces have helped offset weakness in more interest rate-sensitive areas of the economy, particularly housing. Absent a major shock, there is enough strength, particularly in AI, for the economy to continue to maintain positive GDP growth in 2027 as well.

The Consumer is Still Spending, but the Cushion is Thinner

Consumer spending accelerated this past quarter, despite weak consumer sentiment surveys. Stable employment provides support, with the labor market operating near full employment. The unemployment rate remains low at 4.2%, and layoffs remain near historic lows, though payroll growth has slowed. This slowdown is partly due to aging demographics and evolving immigration policies, meaning fewer new jobs are required to keep unemployment stable. A rise in gig work may also be supporting the labor market, particularly lower-income consumers who are more strained by higher costs.

Consumer spending, a key driver of economic growth, increasingly depends on the wealth effects of elevated asset prices. Higher-income households account for nearly 50% of total consumer spending, with a larger share of their wealth tied to equity market gains and elevated home values.

In contrast, years of inflation are straining many American consumers’ finances, and household savings are near historic lows. Higher energy prices, elevated food costs, and rising borrowing rates weigh most heavily on low- and middle-income families, which typically spend a larger share of their income on necessities and have fewer financial cushions. In addition, earlier tax and tariff-related relief is unlikely to provide the same tailwind in the second half of the year.

While overall debt levels remain manageable, delinquencies on credit cards and auto loans have increased modestly, while borrowing costs have risen. Mortgage rates recently surpassed 7% for the first time in more than three years, further weighing on housing activity. Today, approximately 20% of outstanding mortgages carry interest rates below 3%, while roughly 80% have rates below 7%, creating a meaningful “lock-in” effect that constrains housing supply.

Energy and Inflation Keep the Fed’s Task Complicated

Elevated oil prices remain an important counterweight to an otherwise resilient economic backdrop. The effects are most visible in diesel and transportation costs, but higher energy prices are increasingly filtering through to a broader range of goods and services as businesses pass rising input costs on to consumers. With oil prices elevated for eight consecutive months, the inflationary impact is becoming more widespread. Food prices also remain elevated and could face additional upward pressure if the expected super El Niño, a severe weather event that occurs every few years, disrupts planting, damages harvests or strains food supply chains.

Headline inflation, which began the year at 2.4%, has risen to 3.4%, while core inflation, which excludes food and energy prices, remains stubbornly elevated at approximately 2.5%. The longer geopolitical tensions and supply disruptions persist, the greater the risk that higher energy costs become embedded across the broader economy, complicating efforts to bring inflation back to target and increasing the risk of slower growth.

Artificial Intelligence

An Investment Cycle of Unprecedented Scale

AI is no longer just a technology story. It has become a meaningful driver of economic growth, influencing corporate investment, consumer spending through wealth creation, energy infrastructure, capital markets and public policy. The AI buildout has contributed significantly to equity market returns over the past four years and, more recently, has become a growing source of corporate debt issuance as hyperscalers’ cash flows are no longer sufficient to fund AI investments. Hyperscalers, which are the large technology companies that provide cloud computing, data storage and networking services on a massive scale, have been the leaders of this AI investment cycle. Notably, this wave of investment has proven relatively insensitive to interest rates despite increasing reliance on debt financing, as companies remain focused on the long-term expected returns rather than the incremental increases in borrowing costs.

AI is also emerging as an important issue in the upcoming midterm elections as data center development, rising electricity costs, and local infrastructure needs become increasingly visible concerns for voters.

At its current scale, the AI infrastructure build-out rivals or exceeds several of the largest technology investment cycles in history, including the telecommunications boom of the late 1990s, which peaked at roughly 1.5% of GDP, and the railroad expansion of the late nineteenth century, which reached just over 2% of GDP. The scale of this build-out underscores both the magnitude of the current AI cycle and its growing influence on the broader economy.

Percent of GDP from Historical Infrastructure Build-Outs
AI Delivers the Largest Capex-Driven Boost to GDP in History

Source: Bloomberg Opinion (Stijn Van Nieuwerburgh, Columbia Business School)

While the current growth trajectory is unlikely to last indefinitely, spending should remain elevated. Estimates suggest hyperscaler capital spending could reach approximately $800 billion by year end, 45% higher than January estimates, increasing to $1 trillion in 2027 and a cumulative $5.5 trillion by 2030, of which approximately $4.1 trillion is expected to be debt-financed through both the public and private markets.

With two major AI companies expected to go public in the coming months (Anthropic and OpenAI), scrutiny is likely to increase due to recent hacking incidents involving advanced AI systems, the risks of increasingly capable models, and the speed at which they are being deployed. As a result, these companies are seeking liability protection from policymakers.

So far, investors have not seemed particularly concerned about the AI ecosystem’s financial structure, with its circular flow of capital among many of its largest participants. Several companies simultaneously serve as customers, suppliers, investors, and financing partners, creating a highly interconnected network of relationships. For example, Nvidia’s customer concentration has increased significantly: two customers account for nearly 40% of its second-quarter revenue, and large hyperscalers, such as Microsoft and Alphabet, account for nearly half of its data center revenue. As a result, changes in capital spending plans, financing conditions, or adoption expectations among a relatively small number of firms could have large ripple effects throughout the markets and the economy.

Even four years into the investment cycle, we are likely still in the early stages of AI adoption, and history suggests that not every participant will emerge as a winner. The internet revolution, which ultimately transformed the global economy, saw many early leaders fail to maintain their advantage despite benefiting from the initial wave of investment. To date, hyperscalers, semiconductor companies, and hardware providers, the “picks and shovels” of AI, have been the primary beneficiaries. The next phase of value creation may increasingly favor companies that successfully demonstrate how AI is actually improving productivity, lowering costs, enhancing customer experiences, and strengthening competitive positioning.

The Equity Market

Equity Markets’ Narrow Leadership

A relatively small group of large-cap technology and artificial intelligence beneficiaries once again drove index returns this quarter, reversing some of the market broadening seen in the first half of the year. While major indices remain near record highs, the average S&P 500 stock remains well below its 52-week high. The S&P 500 Equal Weight Index, a useful barometer of the average stock because each company carries the same weight, fell nearly 1.9% during the quarter and is now up 10.0% year-to-date. In contrast, the cap-weighted S&P 500 gained 2.3% during the quarter and is now up 12.8% year-to-date.

This divergence reflects the continued outperformance of a relatively small number of large-cap technology and AI-related companies, whose growing market capitalizations have increased their impact on index returns as the index becomes more concentrated. As seen in the chart below, the ten largest companies now account for nearly 40% of the S&P 500’s market capitalization, the highest level in recent history, with technology companies representing most of that concentration. While this leadership has supported overall market performance, it leaves the broader market vulnerable should momentum in these companies begin to fade.

S&P 500 Exposure
Index Weight of the Technology Sector and the Top 5 & 10 Companies over Time

Source: Bloomberg 
Top 5 & 10 lines use the B500 Index as a proxy for the S&P 500
Data: Monthly from 1/30/1993 – 9/30/2026

Earnings Provide Support Amid Competing Narratives

Earnings growth remains the market’s most important fundamental support. Second-quarter earnings rose about 51%, although the headline figure was boosted by sizable, unrealized gains in private AI investments, including Anthropic and OpenAI. Excluding these gains, earnings growth was closer to 29%, still well above the roughly 24% consensus expectation and impressive by historical standards, nonetheless.

Expectations continue to be revised higher. Consensus estimates call for 27% earnings growth in the third quarter, with full-year 2026 earnings expected to rise 33% and 15% in 2027. The equal-weighted index earnings growth, while lower, remains strong at 20% and 10%, respectively. Importantly, despite the current market concentration, earnings growth is becoming increasingly broad-based, with most sectors expected to deliver double-digit growth. Faster earnings growth has reduced the S&P 500 forward price-to-earnings ratio closer to 19x, near its lowest level of the year.

Earnings Growth & Valuation
S&P 500 EPS Growth and Forward P/E

Source: Macrobond, FactSet
Data: Monthly from 1/1990 – 9/2026

Rising interest rates pose a growing risk for equity valuations. With the 10-year Treasury yield now above 5%, bonds offer meaningful competition for investor capital. At the same time, higher yields reduce the value of future earnings, which get discounted using today’s higher rates. Historically, equities come under pressure when interest rates rise quickly, in a disorderly manner, or after several Fed rate hikes. In 1987, the Fed hiked rates three times and long-term yields jumped three percentage points before the market declined, while in 2000, the Fed hiked rates five times before the tech bubble burst.

Demand for Technology Stocks Insatiable, while Increase in Leverage May Increase Volatility

Flows into exchange-traded funds (ETFs) are often viewed as a proxy for investor sentiment and positioning. Notably, technology-focused ETFs are still attracting substantial inflows. Although flows have moderated somewhat from their second-quarter peak, they remain quite elevated.

Cumulative Sector ETF Flows
Since March 30th, S&P 500 Low

Source: Macrobond, Strategas
Data: Available daily from 3/30/2026 to 9/30/2026

At the same time, demand for leveraged ETFs, which use derivatives and borrowing to amplify the daily returns of an underlying index, theme or even a single stock, has surged among retail investors, particularly in funds tied to technology and AI-related themes. Margin debt has also increased sharply, reaching a record approximately $1.45 trillion, nearly 40% higher than a year ago.

This suggests investor positioning has become increasingly aggressive. While leverage can amplify returns during rising markets, it can exacerbate volatility and accelerate selling pressure if sentiment shifts or the market corrects.

Margin Debt Outstanding